Lending to your SMSF? Look out

SUMMARY: SMSFs who were pushing the boundaries on 0% related-party loans face big tax penalties from the ATO.

When the Tax Office wants to close a door, they’ve been known to slam it with a noise that can be heard for miles.

This sometimes happens even where they themselves opened the door and then left it swinging in the breeze for two years.

Last week, the ATO released two rulings that have sewn shut what some believed was a loophole that allowed self-managed superannuation fund (SMSF) trustees to lend money to their SMSFs (themselves or via a “related” party, such as a business or trust) without charging the super fund any interest.

The practice allowed some SMSFs to effectively get around strict contribution limit caps and massively increase the amount of money they were getting into their super funds.

Known as ATO Interpretive Decisions (ATOID) 2014/39 and 2014/40, the statements set out that the ATO no longer believes that this arrangement is acceptable. In technical terms, it means the ATO will forthwith judge the missed income as “non-arm’s length income”.

Non-arm’s length income is taxed at 47% – the highest marginal tax rate, including the current “temporary budget levy” of 2% for high-income earners – within a super fund. This compares with a 15% income tax rate for super in general and would be a stiff penalty for most SMSF trustees.

The practice was not widespread. But clearly dozens, maybe hundreds, (of more than 539,000 funds) were doing it, as the ATO had issued a number of “private binding rulings” on the topic.

Why would a person lend their super fund money at a 0% interest rate? Simply, it was a way of getting more money into super, over and above the restrictive concessional contribution caps (of $30,000 for the under 50s and $35,000 for the over 50s), or the non-concessional contribution caps of $180,000 a year.

The super fund members – who were also the ones providing the cheap loan – were able to build their balance faster in the low-tax environment that is superannuation. And, then, when they turn 60, potentially pay no tax as the pension fund income is paid back out to them.

Now, the ATO has said that loans between SMSFs and related parties should be on “arm’s length” terms. That is, the loan should have broadly comparable provisions as if the SMSF had got a loan from a High St bank.

This will mean there should be a real interest rate, a mortgage, maximum loan-to-valuation ratios and realistic loan tems and repayment provisions.

In one of the examples used in the ATOIDs, the SMSF didn’t have to pay the interest-free capital back until a lump sum at the end of the 20-year term.

Also, potentially, the lender should consider a personal guarantee on the loan amount, which most High St banks do now also.

The decision will shut down something many people thought was an allowable way to get extra money into super.

And it is, to a degree, an about-face from the ATO, who two years ago laid out that a low interest rate, possibly even a 0% interest rate, could be okay.

In December 2012, the ATO said a 0% interest rate could still be deemed a legitimate borrowing and therefore within the spirit of the rules.

At the time, the ATO seemed more concerned about an SMSF being charged an interest rate that was too high by a related party. This would be a clear breach of the “sole purpose test”, where a member would be getting an immediate benefit from their fund – in that case, by getting their SMSF to pay them too much interest. For a recent column on this, see 16/6/14.

But now, some “arrangements” that previously were considered to be potentially okay have been, let’s say, smashed by the ATO.

How are SMSFs going to stay within the new boundaries?

First and foremost, they are going to have to use a realistic interest rate. The ATO is unlikely to set an actual figure for what that is, but banks tend to charge somewhere between about 5.6% and 6% now, which is roughly 1% higher than the amount charged for those taking out new mortgages with a lender. That’s the extra risk that a bank prices for a SMSF loan.

They are going to have to pay back the money to the lender regularly and possibly have a “personal guarantee” from the SMSF trustees, that if the loan goes bad, the individuals will repay the remaining loan to the lender.

SMSFs will still be able to do related party loans. Many do so now by borrowing themselves from a commercial lender (possibly against another property they own) and lending it directly on to the SMSF with similar conditions.

The ATOIDs wrapped up a big week for superannuation and borrowing. Only a few days earlier, David Murray’s Financial Systems Inquiry recommended the banning of “limited recourse borrowing arrangements”, which are the official name of the lending agreements inside a SMSF.

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The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.